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Diamond Chemicals:

Merseyside and Rotterdam Projects

Group 5

Edi Suryanto

Gressiadi Muslim M

Fahmiansyah

Rudianto Nugroho

Wibowo Kristianto

MAGISTER OF BUSINESS ADMINISTRATION

FACULTY OF ECONOMICS AND BUSINESS

GADJAH MADA UNIVERSITY

2011

Diamond Chemicals: Merseyside and Rotterdam Projects


Diamond Chemicals is a leading producer of polypropylene, the polymer used in a
variety of products (ranging from medical products to packaging film, carpet fibers,
and automotive components) and is known for its strength and elasticity.

Diamond Chemicals is producing polypropylene at Merseyside, England and in


Rotterdam, the Netherlands. Both factories are identical in size, age, and plant
design. Merseyside is a factory built in 1967. Merseyside production process is the
production process that are old, the best semi-continuous, and therefore has a total
workforce of more than the other plant competitors.

Diamond Chemicals is under pressure from investors to improve the financial


performance due to economic slowdown worldwide and also the accumulation of
common stock of the company. Revenue per share has fallen to 30 Euros at the end
of 2000 from around 60 Euros at the end of 1999.
The managers of the two mills member reporting to James Fawn, executive vice
president and manager of the Intermediate Chemicals Group (ICG) from Diamond
Chemicals. James Fawn, executive vice president of the Intermediate Chemicals
Group (ICG) Diamond Chemicals and John Camperdown meets its financial analysis,
to review two proposals for capital expenditures that are mutually exclusive. Plant
manager at Liverpool and Rotterdam have been independently compiling spending
proposals, each of which will increase the output of polypropylene from their
respective factories by 7 percent. The staff of Diamond Chemical analyses the
strategy to see that the increased capacity of the company's output by 14 percent
is not possible, but half of that number still makes sense. Therefore, the Fawn will
not approve the plan; he can only finance one in order to obtain approval from the
council.
Since its establishment in 1967, Diamond Chemicals failed to jump in on
opportunities and enhance their production process; for the way they produced
chemicals was old, obsolete, and cost the plant far more than its competitors.
Therefore, Lucy Morris, being appointed to her post almost a year ago, proposed a
£9 million expenditure plan as a solution. The solution was aimed at developing new
methods for the production of polypropylene. Moreover, the new designs would
save energy and improve the process flow. According to Exhibit 2, energy
savings/sales for the first five years after the expenditure will be 1.25%, declining to
0.8% in the next 5 years due to an increase in total sales.
So energy savings/sales would increase by a decreasing rate. The three most
important objectives behind the project were relocating and modernizing tank-car
unloading areas which would enable the process flow to be streamlined, next,
refurbishing the polymerization tank to achieve higher pressures and thus greater
throughput, finally, renovating the compounding plant to increase extrusion
throughput and obtain energy savings. Besides the mentioned advantages of the
project, other more essential positives that can be drawn from the project are
lowering energy requirement for production, increasing throughput by 7% and
improving gross margin from 11.5% to 12.5%. Diamond Chemicals is run by a team
of highly qualified personnel that are experts in their respective fields.

Diamond Chemicals PLC (A): Project Merseyside


Morris conducts a detailed review of operations and finds opportunities for
significant improvements in the production of polypropylene. Some of these
opportunities come from the postponement of the maintenance operation for five
years earlier. Another opportunity comes from the factory to improve the old design
in a way that will save energy and improve process flow.

Merseyside produces 250,000 metric tons of polypropylene pellets a year.


Currently, the average price of polypropylene is 541 Euros per ton for Diamond
Chemicals product mix. The tax rate required in the analysis of capital expenditure
is 30%. Diamond Chemicals has received tank cars Merseyside Propylene from four
oil refineries in Britain. Because the project has increased, transportation should
improve the allocation of tank cars to Merseyside. Tewitt Griffin, assistant plant
manager and direct reports from the Morris proposed the renovation of EPC
production line at a cost of £ 1 million; however, the executive committee had
rejected the project, mainly for economic reasons.

Andrew Cowan assume long-term inflation rate expected is 3 percent per year.
Thus, the real target rate of return of Diamond Chemical (with, zero inflation) is 7
percent. Greystock decided to continue using the discount rate by 10 percent,
because it is promoted in the latest issue of capital budgeting manuals Diamond
Chemicals.
In accordance with the analysis Greystock, Merseyside project meets all four
investment criteria:
1. Additional average annual EPS = 0.018 pounds
2. Payback Period = 3.6 years
3. NPV = £ 9.0 million
4. IRR = 25.9 percent

Diamond Chemical PLC (B): Plan Rotterdam


Proposals from Elisabeth Eustace consists of 90 full-page documents with the
detailed scheme or chart, comments from engineers, strategic analysis, and
financial plan. Based on the analysis of Discounted-Cash-Flow (DCF) and indicated
that the plan has a NPV of £ 14 million and IRR of 17.9 percent. The calculation for
the worst scenario conditions, which is assumed to decline from the same volume of
Merseyside to benefit from the volume of Rotterdam, NVP of £ 11.6 million.

In essence, the proposal mentions Eustace for expenditure of £ 8 million which is


divided into three years to change the path of a collection of polymerization plant to
flow polymerization technology and merging operations. Handling the new system-
driven software designed by a team of technicians is the professor from an
institution in Japan.

Installation of a sophisticated new system cannot be implemented without gaining a


continuous source of supply of propylene. He suggested that to obtain this gas by
pipeline from a refinery along five miles. Diamond Chemical has the option to buy
the pipeline and right of track for £ 3.5 million; then the pipeline can be extended to
reach Rotterdam factories and refineries on the other end. An option has been
purchased several years earlier. A consultant told Eustace if the purchase rights to
the track now and make the pipeline is estimated to cost £ 6 million. Consultants
also predict that for 15 years the value of the right lane will be £ 35 million. This
Option will expire within six months. If the plan of Rotterdam is not done, then the
option right to the path is not used until the end.

The complexity of the technology owned and levels through the mill of a system
would be very expensive to be dismantled. Practically, once the decision was made
to install it will not be refunded. Fawn remind "strategic factors" that Eustace mean
by a clear cost and increased output expected from the new system, as well as from
profits generated as the first European major manufacturers use new technology.
The designer team of German engineers from Glusingen University has tested all
these processes and systems to surpass Japan in reducing costs and improving
quality with a factor of 1.1:1. If the rumors are true, the system will be available
commercially within five years. When it is possible to apply the German technology
in five years, it means letting go off the Japanese investment in the system.

Lucy Morris, manager of the factory on Merseyside, chose to "wait and see" how the
German technology develops. Fawn believes that the flexibility of technological
change differ between plans Rotterdam and Merseyside, and this gives a different
effect on the value of each plan.

Key Issues/problems
1. Why Merseyside and Rotterdam projects called mutually exclusive?
2. How do the two projects are compared based on investment criteria Diamond
Chemicals? What may be taken into account to distinguish it in the rankings?
3. Is it possible to calculate the value of managerial flexibility associated with the
Merseyside project? How, this flexibility affects the attractiveness of investment?
4. What is the difference in the way Elizabeth Eustace and Lucy Morris filed their
respective projects? How do these style differences affect the decision?
5. The project, which must be proposed by James Fawn to the CEO and BOD?

Analysis
1. Why Merseyside and Rotterdam projects called mutually exclusive?
Mutually exclusive projects mean that the acceptance of one project eliminates the
others from consideration. Projects are said to be mutually exclusive when they
cannot be undertaken simultaneously. The projects are called mutually exclusive
because they have to choose one project on the grounds:

a. Statement of a staff analysis of Diamond Chemicals strategy which states that


the project with increased output by 14% does not make sense. This is due to the
limitation in the polypropylene industry that is only able to accommodate an
increase in output by 7%.
b. If the Rotterdam project is approved it is assumed that the implemented
technology not to be changed since it will be very expensive to change the system.
In addition there is a commitment from management that if a decision had been
taken then it will not be changed

c. If they choose Merseyside projects, it will require funds amounting to 9 million


pounds, while the Rotterdam project requires funding of only £ 8 million.

d. Each project presented to the development of better technologies in the future


where the project will have more flexibility options can be easier to choose an
alternative technology that is applied.

e. World economic situation is declining; this might impact the market share of both
projects.

f. The location of the two separate projects is in the UK and the Netherlands. This
also affects capital budgeting because the location of two separate factories will
lead to higher costs and each state has different policies therefore it must choose
one project alone

g. Rotterdam’s project to change the system from the use of polypropylene supply
tank on the train was replaced by using the pipeline including the purchase rights of
way which cost £ 3.5 million. In this case Elizabeth Eustace has already bought the
pipeline right of way. If the Rotterdam project is not implemented then the right of
way will be lost and deadlines 6 months. So there is the possibility of losses for the
company.

2. How do the two projects are compared based on investment criteria


Diamond Chemicals? What may be taken into account to distinguish it in
the rankings?
a. Diamond Chemicals comparison of the investment criteria of the two projects
from 5 factors:
1. NPV is the expected present value of future cash flow. NPV can also be used to
measure directly the value of a project for the owner of the shares.
2. IRR is the discount rate that equates the present value of cash flow in and out in
the future is expected. IRR measures the rate of return on a project, but it assumes
that all cash flows can be reinvested at the IRR.

3. Payback Period is the number of years owned by the company to earn back the
investment in the project. Payback does not capture the entire flow of cash flows of
a project and therefore not a recommended method in the evaluation of a project.
Note, though payback measures the liquidity of a project, and therefore many
companies use it as a measure of risk.

4. EPS or earnings per share is net profit level for each sheet of the company shares
that can be achieved when running the operation. Earnings per share or EPS was
obtained from the profit attributable to ordinary shareholders divided by the
weighted - average common shares outstanding.

5. Strategic factors are other factors that provide value-added when the project is
implemented.

Merseyside and Rotterdam Comparison:

Parameter Merseyside Rotterdam Project


Project

NPV Positive £ 8.99 million £ 14.03 million (expected)

£ 11.60 million (worst


scenario)

IRR > 10% 25.92% 17.89%

PAYBACK Max. 6 yrs 3.6 years 8.2 years


PERIOD

EPS Positive £ 0,018 £ 0.029


Merseyside:
Has the flexibility option of:
1. Ease of doing up-grade of existing technologies. This is because the project in
Merseyside only makes improvements to facilities that already exist.
2. There are opportunities to apply technology from Germany within the next five
years. This is because the existence of Lucy Morris hopes that the technology from
Germany will be the technology that is superior Japanese technology.

Rotterdam:
1. Improvements in gas supply line of polypropylene that were using the railway
facilities which must go through three refineries to provide gas for a single refinery.
This gives the assurance of continuous supply for the plant in Rotterdam.
2. Supply through pipe line project includes the right of way for £ 3.5 million; it is
the price when the sale has reached £ 6 million. According to a consultant, the
selling price in the next 15 years will reach £ 35 million.
3. Application of technology from Japan that has been proven over 3 years to
provide increased output and reduced costs and save energy. Besides, there are
opportunities in the application of German technology in Rotterdam project through
an analog process-control system that offers benefits in increased output and
reduced cost compared with a ratio of 1,1:1 technology from Japan that will be
implemented within a period of five years.

A ranking can be used in the determination of mutually exclusive projects, among


others:
Based on the criteria established by Diamond Chemicals, among others: the NPV is
positive, the IRR is greater than the discount rate that is 10%, payback period is a
maximum of six years, and EPS is positive and which provide strategic factors.

Merseyside Rotterdam

Strengths • Receive positive cash flows • Polymerization process becomes


immediately continuous

• Flexible payment schedule (over


• Higher cash flows in the beginning 4 yr pd)

• Relatively short payback period • Japanese technology proven


successful in Japan
• Can wait to see if German
technology will be better than • Propylene gas pipeline option –
Japanese technology decreased need for railroad tank
car transportation

Weaknesse • Production process is old & not • Lack of flexibility option


s continuous at times
• Committed to project
• Higher labor costs
• If better technology is developed
cannot integrate it

Opportunit • Modernization • Land value


ies
• Increased output/Lower costs • Use of right of way

• Higher market share • Future sale of right of way

• Increased competitiveness

• Technology flexibility

Threats • 45 day facility closure will cause • German technology


customers to purchase from
competitors • Loss of right of way

• Will have to compete to regain lost • Lost cash flows from not
market share implementing the Japanese
technology
• Obsolescence of technology

3. Is it possible to calculate the value of managerial flexibility associated


with the Merseyside project? How does, this flexibility affects the
attractiveness of investment?
a. Yes, we can calculate the value of managerial flexibility associated with the
Merseyside project. Merseyside is the project with a positive free cash flow and
faster project payback period of 3.62 years shorter therefore allowing the
Merseyside project to invest in switching to new technologies.
b. The flexibility affect the economic attractiveness of this project because the
project chance in getting positive free cash flow is faster and the payback period is
shorter so that it becomes an attraction for investors since it is the indication to do
a better investment.

4. What is the difference in the way Elizabeth Eustace and Lucy Morris
filed their respective projects? How do these style differences affect the
decision?
a. Proposals submitted by each manager:
Elizabeth Eustace in Rotterdam projects:
1. More detailed, consisting of 90 pages of analysis
2. Discussing about the right-of-way for pipeline installation project
3. Strategic factors:
- By applying process control technology from Germany it will lower costs and
increase output that is equal to 1,1:1 to process control technology from Japan
- According to the statement that Elizabeth Eustace, Diamond Chemicals will
become a company leader in implementing new technology
Lucy Morris on Merseyside project:
1. The analysis is shorter
2. Only in volunteer projects to improve facilities and improve the production
process are: (1) relocating and modernizing the tank car unloading area which
allows the flow of the process of becoming shorter, (2) improve the polymerization
tank to obtain a higher pressure, (3) renovating the factory and save energy
b. The decision will be based on which projects will be able to meet the four criteria
set by Diamond Chemical, NPV, IRR, Payback Period, and EPS as well as strategic
factors. But other than that the reporting style of Elizabeth on the Rotterdam project
is more detailed and complete, of course, it is also becoming a consideration in
determining which projects will be taken.

5. The project, which must be proposed by James Fawn to the CEO and
BOD?

Parameter Merseyside Rotterdam Project


Project
NPV Positive £ 8.99 million £ 11.60 million

IRR > 10% 25.92% 25.92%

PAYBACK Max. 6 yrs 3.6 years 8.2 years


PERIOD

EPS Positive £ 0,018 £ 0.029

Of the four project selection criteria set by Diamond Chemicals we can see that the
Merseyside project has met all the criteria there. While on the other hand, the
Rotterdam project does not meet the Payback Period criteria. So we propose to
James Fawn to select Merseyside projects. There was also a reason that is included
in strategic factors, namely:
1. Merseyside project has flexibility options that are not owned by the Rotterdam
project so it is easy to upgrade the technology.
2. The existence of uncertainty in the Rotterdam project associated with the use of
German technology in the period of 5 years to come, because the German
technology is still in research stage and not yet proven to be better than the
Japanese technology.
3. The potential loss if the Rotterdam project is not implemented within 6 months is
£ 3.5 million.

Appendixes

A. Calculation Formula

1. NPV
2. IRR

IRR is the rate that forces the NPV to equal zero

3. Payback Period

Paybacks = Year before full recovery + (Unrecovered cost at start of year /


cash flow during year)

4. Earning per share = Net Income / Outstanding shares

B. Graphic/diagram

FCF Merseyside vs Rotterdam


C. Calculation Table

Table 1 NPV, IRR, Payback, and EPS Merseyside and Rotterdam


Years Now 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
FCF M1 -9 1,4 2,66 3,09 3,06 3,02 2,49 2,47 2,45 2,43 2,41 1,68 1,68 1,68 1,68 1,68
TH Payback2 -7,6 -4,94 -1,85 1,21
40,3
FCF R3 -3,5 -8,21 -3,68 -2,28 2,83 2,34 2,96 3,73 4,67 5,35 5,38 5,39 5,39 5,39 5,39 9
-
14,8
TH Payback -11,71 -15,39 -17,67 4 -12,5 -9,54 -5,81 -1,14 4,21
CF after 39,9
erosion -3,5 -8,21 -3,68 -2,28 2,35 1,86 2,48 3,25 4,19 4,88 4,9 4,91 4,91 4,91 4,91 1
After-tax
profit M -0,11 2,09 2,19 2,27 2,35 1,9 1,96 2,01 2,05 2,08 1,25 1,25 1,25 1,25 1,25
After-tax
profit R -4,59 -3,46 -2,17 1,41 1,97 2,65 3,47 4,46 5,17 5,19 5,17 5,17 5,17 5,17 5,17
Discount
Rate 10%
92.891.2
SO4 40

Subject Result
PV Merseyside £18,0
NPV
Rotterdam £9
PV Rotterdam £18
NPV
Rotterdam £14
PV R After
Erosion 15,08
NPV R After
Erosion 11,6
IRR
Merseyside 25,9%
IRR
Rotterdam 17,9%
Payback 3,6 year
Period M
Payback
Period R 8,2 year
- 0,02 0,02 0,02 0,02 0,02 0,02 0,02 0,01 0,01 0,01 0,01 0,01
Annual EPS M 0,0012 0,0225 0,0236 44 53 05 11 16 21 24 35 35 35 35 35
- - 0,01 0,02 0,02 0,03 0,04 0,05 0,05 0,05 0,05 0,05 0,05 0,05
Annual EPS R 0,0494 -0,0372 0,0234 52 12 85 74 80 57 59 57 57 57 57 57
EPS
Merseyside 0,018
EPS
Merseyside 0,029
Remarks: M = Merseyside, 2TH Payback = Time Horizon Payback, 3R = Rotterdam, dan 4SO = Shares Outstanding.
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